In Japan one often finds large arrangements of large stones and rows of raked gravel called Zen gardens, often no bigger than suburban back yards. Zen masters have supposedly laid these gardens out in strange patterns as koans-indecipherable messages that force their students to ponder reality. Near one of these inscrutable rock gardens in Kyoto, Japan, called the Ryoan-ji, is a water basin fed by bamboo fountain that reads, "I learn only to be contented."

Such frustrating signs and messages would also likely apply to investment forecasting for 2010, when analysts must seed every prediction they make with the wry admonition that nobody really knows anything. That caveat often follows forecasts after 2008, when few people saw the dark fledge of multiple Black Swans coming to tear down Wall Street and some of its most venerable financial institutions.

Uncertainty is prompting veteran investors to purchase assets or allocate them in ways they never did before. At last month's Financial Advisor Symposium, Elizabeth Bramwell remarked that she was buying gold for the first time in her career. Steve Leuthold told attendees that his Core Equity fund had 50% of its assets outside the United States, a first for him.

In the past, a good rule of thumb was that the deeper the recession, the sharper the recovery. But we're in an age now of the continued deleveraging at both the corporate and personal levels. That's expected to play out over several years and has several market-watchers suggesting that growth is going to be a lot slower than expected.

Yet there's general agreement with Federal Reserve Chairman Ben Bernanke that the country started to peek out from under the blanket of recession in August or September of 2009. According to the U.S. Commerce Department, real gross domestic product rose at an annual rate of 3.5% in the third quarter of 2009, rising from negative 0.7% the quarter before and three previous quarters of decline before that.

But few Americans feel good about the economy after unemployment hit 10.2% in October 2009, its highest level in a quarter century. If they aren't unemployed themselves, many Americans know someone who is, and that affects them psychologically, dampening their mood, and that, in turn, crimps the spending that might get the economy heated up again. Sharply rebounding markets in 2009 may have had analysts cheering about the success of the government's economic rescue efforts, but by midyear, people were already wondering if perhaps prices were getting overheated in an economy that's lukewarm at best.

With the exception of the last two recessions, rebounds are usually supposed to be big-anywhere from 6% to 8% GDP growth in the following year (after the 1981-82 recession, there were six quarters of GDP growth above 5% and four of those were above 8%). Many economists now, however, are predicting much slower going: the prediction of a Bloomberg survey for real GDP growth in 2010 is a meek 2.3%.

"It is unusual in my thinking," says Boston-based LPL Financial economist John Canally, "that you have the worst recession since the Great Depression and yet the forecasts for the first year recovery is as slow as the recoveries that we got after the 1991 and 2001 recessions, which as you know were quite mild."

Jerry Jordan, manager of the Jordan Opportunity Fund based in Boston, suggests that if we averaged 3.5% GDP growth during the last 15 years we'll probably average 1.5% to 2% for the next ten years. "It won't be negative, it just will be slower," he says.
"I think we'll get into the beginning or middle of next year and people will say, 'Wow, things have really gotten better,'" says Jordan. "But I think that will be a problem because ... the door on excess capacity in oil and copper is going to slam shut. Raw material prices are going to lock it up and [interest] rates are going back up, and that will then snuff out this burgeoning upturn and you could very easily be back in a recession, I think, by 2011."

Perkier Indicators
Despite the slow growth predictions, economists are sanguine about the proof everywhere that the recession ended sometime around the end of summer.

According to Tom Higgins, chief economist at global asset manager Payden & Rygel, while speaking during a conference call in late September, "If you look at a variety of indicators, some of the leading index data-specifically things like the Treasury yield spread and the money supply growth (M2), stock prices, new orders for durable goods, weekly hours, building permits-all are up."

The question is whether these numbers will stay up. Higgins suggests there are only two legs on the stool holding up the economy now: net exports trade and federal spending. And the latter is not much of a leg at all. (Indeed, the Bureau of Economic Analysis says much of the GDP boost came from the now-moribund "Cash For Clunkers" program.) Higgins says his team would rather see support for GDP growth come from other places.

"Over the next year," he said, "what we'll see is the government's going to be spending on the order of $100 billion a quarter to prop up the economy, but really you need to see these other components-consumer spending, housing investments, business investment, really come on in order to sustain the recovery. We think they will."

One obstacle in the new world order is consumers' new virtuous habits. Consumer savings rates, usually one of the less tremulous market indicators, have skyrocketed over the last couple of years from less than zero during the housing boom to almost 6.9% in May 2009. You don't need a Zen rock garden to see a sign of the times: People have begun hoarding money again in ways they didn't in the salad days of easy money. A couple of years after the housing crisis, they no longer think they can use their houses as ATMs or retirement chests, nor wave credit cards like magic wands to make financial emergencies disappear. Nor are they the same sorts of consumers who would buy a new cell phone every six months or a new car or a TV set if the one they've got works.
"We've become Wal-Mart-ized," says Jordan. "Why should I buy it from you when I know I can wait you out and wait a month and then you'll have to cut the price and put it on sale?"

In other words, after 25 years of overborrowing and overconsuming, undersaving and underinvesting, people are adjusting their debt to equity ratios, and that's a long painful hangover for growth.

Savings rates will "probably stay fairly high, and they should for a number of very good reasons," says Karl Mills, the president and CIO of Jurika Mills & Keifer Investment Advisors in Oakland, Calif. "One is that a lot of the economy rides on the backs of the baby boomers, and they're finishing their peak borrowing and spending years."

CNBC economist Marci Rossell speaking at the FPA's Anaheim symposium in October, said she thinks all this higher saving is not a bad thing in the long run. "The trajectory for our economy might look different," she said at the FPA meet, "but it could look different in a way that is less volatile. You might have fewer ups and downs. The highs might not be as high, but I suspect that the lows might not be so low if you come into an economy where people year in and year out are saving 5%, 6%, 7% of their income instead of zero."

Companies Tanked Up For A Rebound
Mirroring the consumer behavior, corporations have also become more virtuous. Non-financial companies have sliced costs and grown cash-fat, holding a record amount of it on their balance sheets. The Wall Street Journal reported in early November that 500 of the largest non-financial companies were holding almost $1 trillion in cash and short-term investments, or 9.8% of their assets, up from 7.9% the year before. This defensive posture by U.S. companies and their cost-cutting amid falling prices is another thing that has primed businesses for recovery, analysts say.

"Corporations have the most cash on hand according to the flow of funds data from the Federal Reserve than they've had in the last 50 years," says Higgins. "So when it comes to the point when consumer spending stabilizes and businesses begin to invest again, you can foresee that businesses have plenty of cash on hand in order to hire more people-in order to invest in technology and to begin that positive cycle upward. So there's good reason to be optimistic from the corporate perspective."

"CFOs get cranky when that cash is sitting there," says LPL economist Canally. "So companies can spend it on acquisitions, they can do buybacks, they can increase their dividends, they can do more hiring and increase production. That cash is going to get deployed somehow, so that will be good fuel for growth for capital spending."

Rossell names a number of factors leading the economy to recovery, not only consumer savings rates but housing prices that have finally come down from nosebleed level into line with median income. But on top of that, she believes that the recovery will be led by exports, as the declining value of the dollar (with the tacit help of the government) has made American products more attractive to a number of resilient economies such as India, China and Brazil that have been insulated somewhat from the downturn and held on to their redoubtable purchasing power.

Meanwhile, there is a debate about two other problems: the fear about both continued punishing deflation (the kind that has Japan's economy wrapped around the axle) and longer term inflation (a worry prompted by the vast infusions of government money flooding into the economy and long-term deficits).

Rossell says that the government stimulus was necessary but could lead to long-term inflation.  "If you spray enough money on this economy," she said, "prices will eventually go up. I believe next year you're going to see inflation rates-which are almost zero right now-I think they could be at 3%, 4% much quicker than many people do, simply because of the money growth."

Jordan, however, thinks that despite the risk of some headline inflation due to commodity price spikes, he believes long-term inflation overall is not a big worry for the U.S. economy. There is too much available labor pushing down wages, he says, and meanwhile, consumers have stopped demanding a lot of things they don't need. The Internet has removed the middleman from a lot of business. Thus he believes the U.S. is still on a long-term deflationary trend and will be for some time.

Stepping into the unenviable position of steward of the money supply is the Fed, which must walk a tightrope and decide when to raise interest rates. Doing it too early in a worry about inflation could choke off the recovery and undo the stimulus. Waiting too long means perhaps a mess like the housing bubble, which led to the mortgage crisis and then the eventual crash of Wall Street giants.

"Bernanke is a student of the Depression," says Canally. "He doesn't want to see mistakes repeated. He doesn't want inflation to get out of control because they'll have to hike further and faster later. So they're walking a tightrope."

Investing in 2010
Recessions follow certain patterns, say economists. At first, companies are cutting back everywhere as a response to declining demand. That allows them to go into upturns leaner, meaner and more profitable. And some of the companies leading the way are ones that have increased their productivity, often through technology spending.

Thus, says Higgins, "The sector that leads in an economic recovery is the technology sector, the reason being that it's inexpensive for corporations to go out and buy new computers-much, much cheaper than hiring new workers. It goes hand-in-hand with enhancing labor productivity. In the third quarter [of 2009], you saw an increase: Though overall business investment was still down, investment in software and equipment was up for the quarter."

Wasif Latif, the vice president of equity investments at USAA, also sees IT doing well, as well as health care equipment and services and consumer staples. "You've seen pretty strong rallies in the information technology or IT sectors," he says. "They have a bit more safety in the way they're positioned because they have just gone through the dot-com bust, so they were a bit more conservative in some of their spending and cash positions and things like that." Health care equipment, meanwhile, has been too beaten down, he thinks, by the health care legislation fracas in Washington, and that has offered investment opportunity.

Jordan has also been investing in health care, though he's cut back from highs of last year, mainly because of concerns about the bills in Congress. He also ducked out of financials completely. The market had priced them for apocalypse last year, and now some analysts think the fire sale prices last March attracted too many people, which cut down the risk to reward appeal.

"They've had their dead cat bounce," says Jordan, "but at the end of the line, the trends of the business aren't that exciting. They still have to raise capital. Regulation is coming. Fundamentally, that sector is still in a bear market."

Financials "seem to have gotten ahead of themselves," Higgins concurs.

Bonds are another tricky area. Interest rates are so low it would be hard to cut them further. Economic worry my have kept bonds popular, but eventually inflation fears could spark a sell-off.

"Investors who are in Treasurys who did well last year because of a flight to quality have not done as well this year at all because of the rates coming in," says Latif. "So investors in more investment grade credit or even high yield credit bonds have done a lot better this year. And while mathematically you can't repeat those type of returns going forward, we think that investors who are in higher yielding assets on bonds-not necessarily high yield bonds but also bonds that are really attractive yields-will be rewarded for owning those types of bonds as opposed to Treasurys."

Commodities are another area of interest for some managers. Latif says that commodities are not only getting a boost as a store of value in a world where paper currencies are declining but that they will also see more demand as developing countries consume more.

Jordan also likes commodities, though he's trimmed back a little because of high valuations. "I want commodities that are coming out of the ground where I believe there is a secular supply problem. Demand may be lousy right now. That will normalize itself.
You know, we didn't suddenly discover something to use other than gasoline to drive our cars," he says. "Iron ore. Copper. All of these things we still need on a daily basis, that we'll especially need as the economy reaccelerates and as more money gets put in the infrastructure, which is inevitable."

Mills compares the ailing economy to a patient on a table-now that he's been defibrillated, how do we stabilize him? That's going to require looking at assets in dynamic new ways. "Do we go back to the way we were or do we go back to something different?" he asks.

Looking to the past has become difficult. Maybe if we want to learn from it, perhaps we must learn only to be contented.